Reigniting the Engine of Growth with the Sparkplug of Invention

Why do patents end up in litigation? Typically, people answer that it is the amount of money at stake. This answer is not wrong. Since the cost of litigation is relatively constant, people should be (and in fact are) more willing to pay lawyers to litigate claims that are very large compared to the cost of litigation. But this is not a full answer to the question. For this answer does not explain why patents specifically should end up in litigation more often. In fact, trillions of dollars in legal rights are exchanged everyday around the globe without litigation. By comparison, the amount of money at stake in patent lawsuits is relatively small.

The Theory of Focal Points

Economist Thomas Schelling is famous for advancing a theory of conflict and cooperation. According to Schelling, even when communication (and hence negotiated agreement) are difficult or impossible, two people can cooperate through a shared focal point. For example, if I told you to meet me in New York City tomorrow but for some reason I couldn’t tell you where and when, we might still meet by going to a famous spot at noon, such as Grand Central Station or the top of the Empire State Building. Our shared vision of these famous spots is a focal point that permits us to coordinate.

The theory of focal points explains why some groups of people fight and some cooperate. When the focal point for a first group is mutually exclusive to the focal point for a second group, conflict emerges. When the focal point is shared or non-mutually exclusive, cooperation emerges. To some extent, all conflict between people can be viewed as a costly renegotiation of focal points.

With Schelling’s theory in mind, let’s revisit the question of patents. What are the focal points for the various parties involved in patent litigation? To simplify the question, suppose there are only two groups involved in patent litigation: “inventors” (or their employers) and “producers” (i.e., the people who sell products or services that practice a claimed invention). Ignore for now the detail that some inventors are also producers, and that some producers are also inventors.

When patents are litigated, the focal point for inventors is on obtaining a large royalty or payment for the right to practice the invention. By contrast, the focal point for producers is on paying a small (or no) royalty or payment to practice the invention. Although both inventors and producers seek profit, at the point in time when patents are litigated, these focal points are mutually exclusive because (at worst) both have incurred costs of R&D for developing the invention. Patent litigation thus becomes a zero sum game.

The Focal Point of Profit

At first glance, therefore, one might think that inventors and producers are doomed to conflict. Before rushing to that conclusion, however, it’s worth noting that in some broader sense, at least, inventors and producers share a focal point — namely, profit.

Profit is an unusually broad focal point. As Adam Smith is famous for pointing out, the voluntary exchange of goods and services creates profit. With profit the focal point, the problem of avoiding conflict between inventors transforms into a problem of identifying and promoting the circumstances in which the voluntary exchange of inventions for cash can take place between inventors and producers.

If such voluntary exchanges never occurred, we might have reason to doubt whether conflict between inventors and producers could ever be avoided. Fortunately, such exchanges do, in fact, occur. Thus, it can be inferred that the conflict arises over how what is exchanged (services and patent rights) should be valued.

Again, this might seem puzzling at first because, at least in principle, there should be no difference in how value is measured. At least within the United States, the same rules for accounting and reporting financial statements apply to both inventors and producers. In principle, the inventors and producers should be able to compare their financial statements, and reach some agreement over the value of an invention.

But since this never seems to occur, the most reasonable inference seems to be that the conflict arises from a difference in how we interpret accounting and financial statements. In fact, it is precisely here that the focal points of inventors and producers diverge. Having had the rare opportunity of working both in patent law and accounting, it has been my privilege to be one of the first to have noticed this. In short, a better theory of accounting would help resolve conflicts over patented inventions and restore a cultural norm of cooperation within patent law. Astute readers should note that, in addition to patent law, Venice was the birthplace of double-entry accounting in the 15th century.

Problems with the Static Picture of Cost Accounting

As described by William H. Waddell and Norman Bodek in Rebirth of American Industry, the theory behind the most dominant method of accounting (which is called “cost accounting”) was developed at General Motors in the early 20th century by Alfred Sloan, Pierre DuPont, and Donaldson Brown. The relevant detail about this theory is that it was designed to measure (and hence manage) return on investment (ROI). To that end, the paradigm that Sloan, DuPont, and Brown had in mind in developing their rules for accounting was a static picture. Specifically, their picture was of what the corporation would be worth in liquidation.

With the picture of the corporation in liquidation in mind, it is easier to understand why so many things that we might intuitively imagine to be costs are instead treated as assets under cost accounting. For example, under the cost accounting system, unsold inventory is reported as an asset. Cost accounting assumes that the inventory could be sold at cost in liquidation. The reporting ignores, of course, the fact that unsold inventory will incur expenses. More importantly, it ignores that what’s unsold before liquidation is less likely to sell at cost in liquidation.

Under the cost accounting system, IP is called an asset on balance sheets. Again, the assumption is that patents can be sold at cost during liquidation. Again, this assumption begs several important questions. Perhaps most importantly is the question of why, if the IP is so valuable, it could not be used to attract financing or revenue, thereby avoiding liquidation. There were (and are) reasonable answers to that question when debt or equity are unavailable for reasons that have nothing to do with the demand for the patented invention. But its salience suggests that there might be better ways to measure the value of IP.

Whereas all patents cost something to procure, market demand only emerges for a handful of all patented inventions. Thus, the system of cost accounting has given managers and investors the perverse incentive to aggregate thousands of patents, inflating their balance sheets, much like we saw prior to the subprime mortgage debacle. Firms invest billions of dollars in new technology, spend millions on patent portfolios, inflating their asset accounts — all before attracting a single customer! Not to be outdone, when the corporation fails, the cost accounting system encourages us to sell the patents at auction, and let third-parties extract whatever they can from the legal rights. On my view, the system of cost accounting, coupled with the shortage of patent lawyers who really understand technology, are responsible for the emergence of the worst kind of patent trolls.

Dynamic Accounting and the Promise of Cooperation

Fortunately, there is now a light at the end of the tunnel. In fact, many corporations have shifted away from the static picture of corporations inherent in cost accounting to a more dynamic picture. Lean accounting, in fact, was practiced at Ford Motor Company almost 100 years ago, before Ford was eclipsed by the success of General Motors. It turns out that cost accounting is a perfectly fine system of accounting when demand is basically infinite relative to the cost of supply. If the market is never cleared, then the corporations that use cost accounting will end up reporting higher return on investment (ROI) than the corporations that use lean accounting. Lean accounting is an inherently more stable mechanism for promoting growth within a corporation in part because it does not tradeoff short-term gains in income against long-term sustainable growth. But once GM started doing it, everybody else in the automobile industry, and eventually the entire economy, had to follow.

Under a dynamic theory of accounting, IP is more like equity than it is like an asset. That’s because the primary value of patent rights is in promoting invention and collaboration, both of which are dynamic because people are dynamic. Elsewhere I have explained how inventors are customers. Within the cycle of growth of corporations, inventors and customers are the source of information about demand. It is no accident that unmet need was considered by Judge Learned Hand to be the most important of the secondary considerations on obviousness.

By contrast, assets are static. By adopting rules for reporting and managing the IP that are more consistent with the actual mechanism whereby it increases profit, we will in turn discourage wasteful conflicts. A very important corollary to this is that stronger patent rights would be beneficial in promoting collaboration and avoiding conflict. Strong property rights discourage people from litigating what could be solved through negotiation at an earlier point in time. As Robert Frost noted, “Good fences make good neighbors.” With a change to the accounting rules, these early negotiations will happen more often.

Finally, let me emphasize that changes to financial statements need not be dramatic. For example, the simple addition of average daily debit and credit flows for each balance sheet account would permit the shift in managing and investing that I’m advocating here. Since most accounting is now done by computers, this kind of change is actually very cheap. The value of inventions could then be measured easily by comparison between the average daily debit and credit flows before and after an invention had been implemented. Suddenly, inventors and producers have a numerical way to measure the value of an invention.

[Michael Martin is a former in house counsel and founder of Venetian Capital Management.]

@Michael F. Martin Actually the problem is multi-facited. significant invention is stolen through various every dirty trick in the book from myself and my grandfathers. Then horse traded until the full profeteer value is reached or litigation fraudsters claim previous conceptions to steal it.Companies by there nature want to obtain patents for nothing or as cheap as possible.Companies also runup huge R+D costs on poor decisions on project investments and the belief that there employees can actually produce invention. Companies then view ideas as worth nothing because of there huge R+D expendatures.Companies are rarly willing to discuss invention compensation with inventors without full disclosure then they have the option of claiming Preexisting R+D or inter company memos or previous existance in some non matching pto drawings from 30years ago ecetra.See my web site for full scoop at http://www.worldsonlyinventorofsignificancearguably.com I checked the website you refered to but it is full of balogna like the entire pto files on inventors they may be the developer theftors but there not the concievers of the original ideas.You need to remenber our patent system is based on first to file that equals the biggest liar to run inventioin back into time wins.

Any healthy organization of people needs to consider both time and money in deciding how it will earn profit. Cost accounting focuses on money (i.e., time-averaged costs). Lean accounting focuses on time (i.e., frequency-averaged costs). We need both. Every financial statements should include both. FASB 157 didn’t solve anything because it merely substituted one time-averaged measure for another.

@Michael R. Thomas

The problem is not with large corporations. The problem is with large corporations who do not cooperate with inventors AND inventors who do not cooperate with large corporations. Read Malcolm Gladwell’s piece about the inventors of television on this very point:

In order to restart our black hole stagnated patent system we first need to realize that all the good new product inventions are being placed into the wrong names with the inventor recieving nothing.Large corperations want to pay nothing for original ideas they will either defeat inventors in court by claiming previous invention or attempt to hire inventor in long enough to pick his brain then toss him away like trash. we need refusal to deal legislation to ensure fair compensation like 33/68 profit splits after expences.Insignificant invention clogs our present system and antiquidated inventor determination methods prevent correct inventor from establishing greatness.

I really like the key point in your argument that is not heard enough in these days of patent bashing. If the patent system and courts, (EDTX notwithstanding), were more unified in promoting strong patent rights, and that includes rigorous examination and post examination practice such as reexam, then litigation would see much needed improvement in the form of fewer suits based on dubious grants and more quantitatively satisfying results including valuation and settlement as you note.

One question though – since much inventive activity falls outside the day to day accounting activities linked to sales cost of sales and the like and into murkier areas, such as non-recoverable engineering, R&D and product development, how do you propose incorporating such costs into the IP valuation model?

“Are you referring to the final disposition of the case, or to the rejections made in a FOAM?”

All of it. The application can be deemed low quality at any point in prosecution or thereafter. Every application starts out at “perfect” when I see a number pop up on my docket, then they usually progress downwards as I examine it, some come back up upwards sometimes. You have to remember, low quality patent/application is a broad term encompassing many things at many different times.

“Perhaps an overly broad independent claim is common known to those in the relevant art, but not the dependent claims.”

Perhaps, perhaps not. If not, then you have found an indicator of a low quality patent.

“You mean you actually see cases where the lawyer is so st*pid to claim an algorithm, without anything else? Or a software claim without a computer readable medium?”

I don’t personally, but I know people who do.

“By this you mean doing anything but claim the exact specific narrow ass embodiment disclosed by the inventor. Got’cha. Keep crying about that one; nobody cares and nobody interprets 112 like you do.”

Or by that I meant “inequitable conduct” plain and simple. Yes, there are interpretations of things which I take issue with, but that’s besides the point. BTW, didn’t you read the case from the last thread? Looks like at least one Fed Circ. Judge agrees with me Sadly, he feels like it should be nearly impossible to prove that wrongdoing ever took place. Why? Because, as in Markman, the inventor is deemed by the courts to be too stupd/ignorant to comply with 112 so they give them a pass.

“You’re an examiner. You no doubt would find a reference disclosing an air filtration for an airplane and a reference disclosing a method of making tennis shoes to be easily combinable.”

Or maybe a reference describing an air filtration for an airplane that used x filter and a reference for the same using y filter might be a better example of easily combinable references.

“I suppose that no mechanical patent should ever issue. The laws of physics don’t change and the result of any combination of mechanical parts is predictable.”

I don’t think you read point 10 correctly, but maybe sometime you will. I see no reason why there cannot be mechanical patents issued, but there might not be many cases of unexpected results in such an art, I don’t know it that well. Then again, I can think of plenty of things that aren’t all that predictable in the mechanical arts. What is the bonding strength of x when bonded to y with c bolt? Have to run tests on that when x is a new material.

As I said last year, if my patriotic personality and Patently-O posts offend you, tough, live and let live.

I am an American through and through all year long, not just on Independence Day. This is a special day for me, my wife’s and my Anniversary date is also July 4th – we’ve been together 33 years all told.

It makes me happy to give thanks and give credit where it belongs – I am thankful for the miracle of another day living in America, and one day less under President Bush’s cronyism policies.

Please remember this Independence Day and after— being top dog isn’t everything, but it is the American thing.

On mark to market – with the increasing risk being taken by financial and PE firms, the moves to create transparency have been needed, and should be used as a better way to value the balance sheet, not bankrupt well managed companies (e.g. did Bear Sterns, et al, have the liquidity coverage necessary for the risk it was taking on?). Accounting measurement of previously unbooked pension liabilities, balance sheet fluctuations of mortgage valuations and options expenses have greatly increased our visibility of the risks in the system. Great write up on this topic here: link to informationarbitrage.com

Tying patent value to profitability is needed, but I’m not sure ‘lean’ or ‘cost’ accounting gives us a path to getting there. R&D expenses are period expenses that do not match revenue timing which creates an issue in measurement to be sure. The linkage from the result of R&D expenses (which is best done as problem solving from assessing user needs) in the form of IP into products is what’s needed. The analytic tools for that linkage have to stretch across IP, accounting, engineering and marketing departments. Internal measurement systems have a long way to go here.

On valuation – a firm can value a new feature and its impact amongst the larger product (new or existing) by testing it via conjoint analysis (see Wikipedia for a good starter definition). While most on this board aren’t trained marketers, the AMA has a number of articles on how to assess the incremental value of features and industry has been using it for years. These tests allow for real time assessments instead of having to rely upon the after-the-fact measurements.

On the impact of S.C. recent rulings – I’m not sure I feel the same about whether patents still have a place as the innovation spark plug. I’m leaning more towards the test of market acceptance given capital costs are low, production costs are largely variable as a result of global low labor cost accessibility, and selling a product globally doesn’t require mass physical distribution. In this sense, ‘speed to market’ is the new ‘patent protected’.

In estimating how an invention will impact profitability, managers and investors should consider both shortened-time to sale (through lean accounting) AND the magnitudes of costs of sales and sales (through cost accounting).

I am not a CPA, although I was trained in accounting by some very experienced CPAs, both in-house and through a public auditing firm. More importantly, as an investor, I spend quite a bit of time reading financial statements and thinking about their interpretation. In this I have been self-taught through reading of Benjamin Graham, Warren Buffett, and Charlie Munger.

@Wishful

Thanks very much for weighing in. I have to push back at the comment on how mark-to-market is a substitute for average daily debit and credit cashflows for each balance sheet account. Marking balance sheet accounts to market tells you what OTHER people are getting NOW for similar assets. Not what YOU are getting NOW. I cannot understand how Enron was not enough of a lesson on this. Bear Sterns should have ended the debate about the usefulness of using market-to-market to track liquidity.

I was trying to keep the argument concise, so I didn’t get into the specific reasons for my proposal that we track average daily debit and credit cashflows for each balance sheet account, so here goes a quick explanation.

First, I am not advocating a switch from cost to lean. I just think our current system of cost should be supplemented with lean measures. The two pictures are complementary, and provide different insights into how value is created within a firm. In particular, cost accounting focuses on time-averaged measures of cash-flow whereas lean accounting focuses on frequency-averaged measures of cash-flow. I elaborated on this point in a post on my blog:

Of course, it is possible to run a firm without a complete picture of both time-averaged and frequency-averaged measures of cash-flow (to wit, we have done it for most of the past 100 years). But relying on only one makes certain managerial decisions much more difficult.

In the case of inventions, there are two ways that value can be added to a firm. First, the invention can be for a new product or service. The time-averaged picture provided by cost accounting serves relatively well here. You look at the time-averaged sales and subtract the time-averaged costs of sales, and do a little discounted cash-flow analysis of these and there you have a number.

But the time-averaged picture does poorly with inventions that improve existing products or services. How can you tell how much of the improvement is due to the invention versus other factors? A frequency-averaged picture of cash-flow (such as could be reconstructed from a combination of average daily debit and credit cash-flows) permits a manager to see how much faster a process was completed, or an inventory was turned over, even at a fixed price. This isn’t the only way to estimate the value of an invention, but it’s better than many of the existing alternatives, and it’s certainly better than simply measuring as the cost of procurement (which is how patented inventions are carried on asset accounts under cost accounting at many firms).

When there are multiple overlapping patents, things are messier. But again, having a frequency-average picture of production helps sort through the question of what invention contributed what to decreasing costs or increasing sales.

I am not proposing a particular valuation methodology. I am proposing that we make more information about how firms are creating value available to the public so that everybody has the chance to develop their own valuation methodology — one that includes information about firm-specific liquidity.

pshaw is spot on covering the accounting for the topic as financial systems don’t run on Mr Martin’s assumption of cost accounting – no Fortune 1000 company uses solely a balance sheet view to drive its business. Additionally, no start up relies upon its patents’ value to be bought out without the test of market validation.

Those initial remarks said, Mr Martin’s premise that accounting with a traditional historical costing view makes for flawed decision making. Peace. Mark to market is an important facet to today’s financial measurement systems. This new tool also has problems on the other end of the pendulum, e.g. Bear Sterns liquidity problems, but we accountants do see the issues in a historical cost based view.

A patent’s worth is the step of its novelty from prior art *combined* with the importance of the feature that it impacts on a product/service based on user input. Less valuable patents are such because they improve or create features/benefits that provide little additional pricing power v. the bundle of features offered without it (because that feature has lower value to the consumer/user). Refer to market research using conjoint analysis for how this is measured.

Patent valuation then comes from measuring the market in terms of sales/profits (quantitatively via research of competitors and end consumers), evaluating the prioritization of feature sets, and then allocating value to each feature and its corresponding IP value driver along with substitute methods. On this theme, accumulating patents makes for a prudent strategy if you can aggregate a true monopoly of a series of alternative means to a highly valued innovation stream – a much more powerful incentive than bulking up IP to create a bigger balance sheet. When building a portfolio, those companies that have locked up IP on high value feature sets *in the minds of buyers* have a better chance to sustain higher profits, see Gillette on razor blade patents. Sound like measuring the value of a patent is complicated? It is. To get a flavor for the new complex world we’re in for accounting, see the Black-Scholes model for stock options and the regulatory requirements of SOX.

Let’s move on to a far more important discussion point from what ‘should be’ in the world of the benefits of a ‘strong patent system’ to what is in progress in the real patent landscape. This discussion makes no mention of KSR, of MercExchange or of the general opinion of the public on using patents as a sword. The combination of these elements have brought about non-lawyers to change the rules on the PTO’s behalf, which in turn changes any related value calculation. What is the value of the typical patent as a result? Generally far less than before for a great number of patents issued and in progress. In fact, here is where Mr Martin has the greatest point to make: We can no longer look to litigation or licensing history pre-KSR as a benchmark for what another patent’s value is going forward!

Think of it this way, Ray Kurzweil talks of the increasing speed of innovation. If we take that assumption to heart, that innovation is happening faster each year, then where does a patent system fit that takes 3 years to issue on more and more incremental improvements and results in an ‘asset’ that lasts for for 20 years? A disjointed future sits between these two views that is being corrected.

I would like to see a list and analysis by one of your patent litigators as to why some patent infringement lawsuits settle early, some settle late and some never settle, despite the fact that settlement saves both sides very expensive attorney fees.

I have owned two fantastic Ferraris, the classic twelve cylinder with six two-barrel carburetors variety (and a magnificent 52 foot custom classic yacht) but now, since the patent scene has turned way, unforgivably way, against mom and pop inventor businesses (even though I’ve successfully manufactured various great products along the way), I drive a 22 year old Town Car (but don’t cry for me – it runs in perfectly in comfortable condition, and I have a custom painted antique 32 year old Town Car (19.2 foot long!) for sale – the first $7.5K takes it!).

I am trying to write-up another invention for patenting, based on the idea that you cannot take “it” with you, but, if you handle the family accounting affairs right, and keep your credit scores way up, you can take the bank(s)’s “it” with you even if you die old.

My banking philosophy is, phuck the banks, they own more of We the People’s government than We do (only kidding, or maybe not, after a long hard grueling week and an hour and a half after happy hour est on my favorite holiday weekend).

That’s funny, because I don’t think anybody else can – and I suspect even the author can’t.

Go ahead, give us a summary of Martin’s argument. Make sure you explain how “focal points” and “dynamic accounting” actually drive patent litigation. And how “the simple addition of average daily debit and credit flows for each balance sheet account” would reduce patent litigation. While you’re at it, name one tech company that pays its managers bonuses based on assets growth.

Listen up, everyone. E6k’s going to educate us on accounting, corporate incentives, and the agency problem.

First, a disclaimer. I took accounting classes, but sadly I understand accounting about as well as the average accountant understands patent law, i.e. I don’t. So I suppose if I were CEO of a large corporation I wouldn’t be influenced by cost accounting, but then pigs might fly.

Still, I suppose that there might perhaps be some CEOs who are happily unhindered by a proper understanding of double entry (notice I don’t exclude that they might theoretically understand it, after all I should in theory, just that like me they never really grasped it properly), and it seems that this may actually be a help to their success! That’s nice to know.

As for the proclaimed shortage of patent lawyers who really understand technology, surely if they don’t have a reg. number then they aren’t patent lawyers, or at the very least they are not patent attorneys. Patent litigation attorneys perhaps, but not patent attorneys. Just ask the OED if you doubt me. Of course, if they have never encountered the delights of 37 CFR 10 and 11 they may be blissfully unaware of exactly what they are not.

If, OTOH, they do have a reg. number, then they must have met the requirements to prove their technology educational background or they couldn’t take the test. Oh, I know there are a few who managed it with the minimum number of credits in some questionable classes, but I’m sure they are a minority.

To me the most interesting thing about Sumerian accounting records is not how they were done, but what they say. Specifically, the huge amounts of timber that they record was exported from what is now desert. You think the deserts of North Africa and the Middle East got that way entirely at the hand of nature? Think again. Man has been destroying the environment for thousands of years.

“If the list goes on ad infinitum, then virtually all patents or applications would meet the definition of a low quality patent.”

Not literally ad infinitum. “The list goes on forever, etc, etc …” how’s that? The fewer or the things on the list the higher the quality. I doubt if even .1% of patents are “perfect” quality, but there are some that are “high” and some that approach “high” after prosecution.

“Where does this perverse incentive come from?”

You’re not very accounting inclined are you? I’ve never even been formally introduced to it and even I can tell what he’s talking about. He’s referring to the incentive to have assets showing up on your accounting books. Patents show up as assets under certain accounting schemes.

“And how does this “swelling” of the balance sheet help the managers?”

They get bonuses based on the amount of growth of their assets is what he is saying I believe.

“show me a patent lawyer who doesn’t understand [the] technology [in question] and I’ll show you either an unemployed patent lawyer or a patent lawyer just waiting to be smacked with a malpractice suit.”

Perhaps, but I know of at least one or two, and I know several that I seem to know more than they do about the instant application, astounding though that may be. Several others seem to be faking it pretty well.

Then again, as an aside, sometimes I get cases about oraganic chemistry. I had like 3 chem classes in college how in the he ll am I supposed to know anything about orgo? So I guess the same happens to practicioners sometimes.

And cases with trimethylbenzene-9-blah blah consisting of aromatic rings and all this mess. Do you really think that someone who has never heard of that stuff has a chance of examining such very well? Remember this practicioners, if you want the application examined well, make sure that you make the most comprehensive claim of the statutory class you want examined be classified somewhere near the class that should be examining the subject matter you consider likely the most inventive part of the application. I.e. if you make a new type of aluminum alloy, and you made it specifically for use in making bicycle frames, and specifically to make a certain bike, then it might be unwise to include claims to “1. A method of making an aluminum alloy comprising x” and “2. A method of making a bicycle out of the aluminum alloy formed by claim 1″ since someone who examines bicycles will be examining your composition claim and won’t have a dam clue about all the chemical processes used to make the aluminum alloy. But hey, up to you, just throwing it out there since I’m seeing it more and more often.

“In my view, the system of cost accounting, coupled with the shortage of patent lawyers who really understand technology, are responsible for the emergence of the worst kind of patent trolls”

Perhaps the litigators don’t understand technology, but show me a patent lawyer who doesn’t understand technology and I’ll show you either an unemployed patent lawyer or a patent lawyer just waiting to be smacked with a malpractice suit.

Michael Martin wrote: “On my view, the system of cost accounting, coupled with the shortage of patent lawyers who really understand technology, are responsible for the emergence of the worst kind of patent trolls.”

The worst kind of patent trolls (= the most successful patent trolls) are not those who understand technology, but those who understand the Federal Rules of Procedure, its relationship to patent law, and who lack the sort of conscience that prevents ordinary citizens from behaving like jackasses for the sole purpose of pocketing some coin.

They also tend to drive Ferraris and own homes in Aspen.

Speaking of which, how is our friend the Patent Troll Tracker doing these days? I seem to recall that Ray “You Hurt My Feelings” Niro more or less promised an extended period of misery for PTT. I wonder how that’s working out.

Concerning the analogy to equities, I think patents in large part should be analogized to long call options. They are invested in because they may turn out to have value in the future, the rationale for owning them being part hedging and part speculation. Beyond that, the information available for making individual decisions is often so incomplete that firms can do nothing more than implement prophylactic policies. The value of particular inventions may be essentially unknown, but you don’t want to have failed to secure the option on the invention that does turn out to be valuable, so you buy as many options as you can, i.e. file as many applications as possible. At the same time, given the speculative nature of each of those individual investments, there is sensitivity to cost, resulting in a minimal investment in each one, i.e. applications of low quality.

Regarding the author’s statement that:

“Strong property rights discourage people from litigating what could be solved through negotiation at an earlier point in time.”

I think this is perhaps not precisely what the author had in mind. Strength of rights coupled with clarity as to their boundaries will reduce litigation. The system as it is constituted today generates many patents that are rife with ambiguity for which there is no cost-effective means of resolution. This creates an added incentive for filing applications: a patent may turn out to be valuable because its ambiguous terms arguably cover something practiced by another – giving it enough leverage to extract settlement value or maybe even a big verdict – even though the inventor never conceived, and the patent never described, the thing it is now alleged to cover. Much of today’s controversial litigation involves exactly this scenario. This arguably demonstrates that the system provides strong rights, because the patent owner wields considerable power in this scenario. But it is all possible because of lack of clarity as to the boundaries of the patent rights. The system essentially forces defendants to purchase business certainty from patentees where the patent system itself has failed to provide it.

I think the reality is that the patent office is a poorly run, poorly equipped institution that is tasked with doing a job that is virtually impossible even under the best of circumstances, namely, determining, with reasonable certainty, against the backdrop of essentially all human knowledge, the extent of the contribution, if any, represented by whatever is described in an application. Combine this with the additional fact that there are too few incentives, and significant disincentives, for the applicant to assist the PTO through clarity, specificity, detail, and explanation, and you get today’s system. I don’t believe there’s any way to generate reasonably reliable valuations for the products of this system.

Michael Martin wrote: “On my view, the system of cost accounting, coupled with the shortage of patent lawyers who really understand technology, are responsible for the emergence of the worst kind of patent trolls.”

While there is a shortage of patent lawyers who really understand technology, there is also a shortage of CEOs, business people, inventors, etc. “who really understand technology.” I don’t think “really understanding technology” is the issue behind patent trolls.

MMartin wrote “Nobody who really understands how inventing is done or how it creates value within a firm would ever demand that a certain number of patents be filed within a certain amount of time.”

I think in the case of certain biotech sectors the relationship between research milestones, discoveries, and patent filings can be fairly closely tied, so that the demand for a certain number of patents is a reasonable one.

Mike, the reason I ask is that the following leads me to believe that you’re not expert in accounting, whatever your skill in law and science:

“Thus, the system of cost accounting has given managers and investors the perverse incentive to aggregate thousands of patents, inflating their balance sheets, much like we saw prior to the subprime mortgage debacle. Firms invest billions of dollars in new technology, spend millions on patent portfolios, inflating their asset accounts — all before attracting a single customer! Not to be outdone, when the corporation fails, the cost accounting system encourages us to sell the patents at auction, and let third-parties extract whatever they can from the legal rights.”

Where does this perverse incentive come from? With regards to internal development, the R&D costs themselves are expensed, and don’t show up on the balance sheet. Only the relatively modest filing and legal costs for the resulting patents are capitalized – this is typically a very small proportion of the total R&D budget. (Costs of defending a patent should also be capitalized.) And how does this “swelling” of the balance sheet help the managers?

With regards to purchased patents, these do show up on the balance sheet, at the purchase price, and amortized over their expected life. Note that in an asset purchase, such as with the purchase of an entire company, any excess of the purchase price over fair value is booked as “goodwill.” Again, however, I don’t see where any perverse incentives come in. And I don’t see any link to patent litigation at all.

Finally, you say “when the corporation fails, the cost accounting system encourages us to sell the patents at auction…” This is just nonsense. The cost accounting system has nothing to do with it. If there is anything of value to sell when a company is liquidated, then it should be sold, for the best price that can be obtained. That’s just good sense – accounting practices are irrelevant.

Come on fellas. Given the viciousness with which you’ve attacked other people brave enough to post articles on this board, e.g., Arti Rai, it seems that you’re giving Mr. Martin a free pass. As far as I can tell, his premises are flawed, and his analysis doesn’t lead anywhere. Maybe I’m missing something…

Re:
“Creatively does not always go hand in hand with intellectual capacity.”

I agree – I think we may be on the same track. In fact, my wife’s reading a book that says studies show the genius IQs tend to be less creative than high IQs like 130 or 140.

I wrote above, “One must be bright to be funny.” I didn’t say one needed to be a genius to be funny.

However, my guess is George Carlin was an exceptional genius, exceptionally creative and a pure genius philosopher.

I came to my “genius philosopher” thought about Carlin only after recently seeing a previously aired “Inside the Actors Studio: Interviews with Hollywood Celebrities” with George Carlin. Carlin’s insights into human nature were astounding.

“[I]t costs a lot of money and a lot of intellectual effort to appreciate the real worth of a patent. ”

This is where Coase’ negotiation theory comes into play, and where a seminal law review article by (now) Judge Guido Calabresi and A. Douglas Melamed should gain an important role in the policy of patent law. See Property Rules, Liability Rules, and Inalienability: One View of the Cathedral. 85 Harv. L. Rev. 1089 (1972).

“A low quality patent (or application) is a patent with one or more of the following:

1. No patentable subject matter in the claims (especially relevant when the invalidating art is known at the time of filing)

2. Little to no patentable subject matter in the specification”

Well, if I were to believe an Examiner’s opinion, almost every application I’ve prosecuted was ‘low quality.’ Strangely, I end up getting the claims allowed, often without making amendments outside the scope of the originally filed claims. Are you referring to the final disposition of the case, or to the rejections made in a FOAM?

“3. Claims directed to inventions that are commonly known to those in the relevant art”

Perhaps an overly broad independent claim is common known to those in the relevant art, but not the dependent claims.

While Carlin is and has always been my number one favorite comedian since I saw Carlin at Carnegie at the age of 12, I would dispute your point about intelligence being a necessary prerequisite to being funny.

I used to think that too (along with great acting) but in my time I have definitely known and seen genuinely funny people who were not that bright. Creatively does not always go hand in hand with intellectual capacity.

“In the past, some large corporations have given their IP lawyers a goal of getting X number of patents by year end. That kind of goal is a direct consequence of the incentives of cost accounting.”

I disagree. This kind of goal is due to corporations wanting some sort of metric by which to measure the “value” of their legal and/or R&D departments. These departments are typically cost centers, not profit makers. The CEO needs a number to help him decide whether or not efficiency is increasing, which this metric provides.

Also, other incentives exist. For example, IBM touts itself as an innovative company because it gets thousands of patents a year. The desire to obtain patents here is certainly not due to cost accounting.

Does the cost accounting method account for depreciation? I mean, it’s pretty well recognized that assets can lose value. Why doesn’t this apply to patents? Or is Mr. Martin saying it is not applied to patents?

Quality does not equal quantity. Some firms will promote inventing better than others, and those firms will generate more quality patents faster than others. I have not argued that filing more patents is always bad.

I always seem to have the opportunity to comment only after a long list of prior comments have been made. But I profit from having read an extensive list of commentaries. Where to begin?

“…stronger patent rights would be beneficial in promoting collaboration and avoiding conflict. Strong property rights discourage people from litigating what could be solved through negotiation at an earlier point in time.”

Patents are litigated because the law admit so many pitfalls that would allow a defendant/infringer to escape liability. The rules are: off-or-on. The invention is obvious or not obvious. The disclosure is adequate or not adequate. Inequitable behavior is fatal.

There would be less litigation if a court could award half-a-loaf to a Patentee with a defective specification, based on principles of equity. For example, awarding damages and/or a compulsory license at reduced rates, but no injunction. Then the parties would settle.

Now for the bigger question: how do companies value patents? Well, it’s a big mystery. By that I mean that the valuing of a patent may be an intractable challenge. New prior art may surface. Alternate technology may be invented by others. Who can predict how a court will rule on the issues of validity and infringement? Basically, the subject is shot-through with uncertainties.

Further, it costs a lot of money and a lot of intellectual effort to appreciate the real worth of a patent. Patent attorneys act like high priests and are simply trusted to obtain the “best protection possible”. But is that protection worth anything? That’s not the responsibility of the patent attorney. So firms simply pour money into a hole in the top of the black box and then post the value of their patents as equivalent to their cost, or use some other theory to post a higher value. For the example, a patent portfolio could be given substantial value when it is part of the “goodwill” acquired in a corporate takeover.

The problem is that clients, inventors or the corporate employers of inventors, have over-blown aspirations when they set-out to obtain patent rights, and really have only the vaguest understanding of what makes a patent valuable.

I tell my clients that a valuable patent has to start with a valuable invention. Without that, there’s nothing. A valuable invention represents something that people want to have and for which they are willing to pay a price that is more than the cost of production. Assuming you can obtain a valid patent, you still do not have a winner unless there are no close substitutes for the invention. And if a close substitute doesn’t exist today, it may come into existence tomorrow.

A valuable patent, if well drafted, will focus on a have-to-have-it feature or characteristic. There has to be a bottleneck that can be covered by the claims in order to allow the patent to work its money-generating magic. Without there being such a bottleneck, a patent has only modest value, eg for bluff, harassment or publicity. And oh yes, people must want to have access to the invention and there should be no close substitutes. I think I said that before, but it is worth repeating.

“However, the estimated fair value of the patent till expiration prior to its purchase was $10 million, which is the amount being amortized over the useful economic life. The carrying value of the patent at year’s end totaled $8 million, with a remaining life of approximately 16 years.”

Sorry, jaoi ™, if it’s not on the books as an asset, you can’t amortize it. So, in order to amortize the $10 million over the life of the patent, you would first have to write the asset (on your balance sheet) up from $1M to $10M. And yes, this would have to show up on the income statement. However (keeping in mind that I’ve had a grand total of one accounting course), I can’t imagine that accounting rules let you realize that $9M “profit” based on a change in valuation methodologies.

“So …. if a company gets sued for $100M and they settle for $1M, does the company get “relief of legal judgment” asset … let’s make it easier … perhaps the company bought the patent for $1M upon which the original suit was brought.”

Sort of, but only if they had earlier booked that $100M as a reserve. In that case, the $100M would have shown up on an earlier income statement as an expense. In the period of the settlement, the reserve would be drawn down, yielding income…

This is why you shouldn’t rely on an income statement alone. There’s a lot of information in that cash flow statement.

“The “relief of royalty valuation methodology” does not involve putting $10M on the books as an asset since it is a “perceived” royalty that need not be paid to the patent owner from whom they bought the patent because they bought the patent for $1M.”

So …. if a company gets sued for $100M and they settle for $1M, does the company get “relief of legal judgment” asset … let’s make it easier … perhaps the company bought the patent for $1M upon which the original suit was brought.

Where does this show up on the balance sheet? Unless it is on the balance sheet, nobody cares. However, if it makes it to the balance sheet, you should (I think, I’m no CPA) reflect the change on the income statement. To me it sounds like accounting hocus pocus that would make me, as an investor, run and hide.

“As long as I can remember, I’ve thought of humor as one of the most difficult thought-inventions. One must be bright to be funny.”

Amen brother. The more I think about and reflect upon the humor that I like, the more I have realized just how smart, quick, and insightful a good comedian needs to be … particularly to do standup or improv.

One factor that makes proper accounting of the worth of a patent difficult is that a patent is not a right or permission to do anything at all, but rather the right to exclude others from doing something. A patent’s value depends directly upon how it is perceived by any competitors, rather than simply how it’s worth is perceived by its owner. Until it is licensed or litigated, the patent owner can enter just the cost of patent acquisition and maintenance on a balance sheet (approximately the same for most patents), since he can only guess at how others might perceive its worth. Even when a patent owner makes a profit on producing goods or services embodying a patented invention, attributing how much of that profit could be attributed to the existence of the patent rather than simply the added value of the goods or services themselves depends on the competition and hypothesizing what would have happened in the absence of the patent.

I do have to say that pds raises a good point about there being other reasons for a company to file many applications. But, even with that said, we must remember also that even the fostering of the inventive spirit and culture is all for the purpose of generating profit and Mr. Martin may have accounted for this. Perhaps he will be good enough to tell us.

The “relief of royalty valuation methodology” does not involve putting $10M on the books as an asset since it is a “perceived” royalty that need not be paid to the patent owner from whom they bought the patent because they bought the patent for $1M.

However, the estimated fair value of the patent till expiration prior to its purchase was $10 million, which is the amount being amortized over the useful economic life. The carrying value of the patent at year’s end totaled $8 million, with a remaining life of approximately 16 years.

Of course, PCX would have a opinion letter of sorts from a patent attorney and an opinion letter from a CPA.

“I should have added a P.S. to the post — the incentives of cost accounting are probably a big driver of the enormous number of low quality patents filed at the PTO. In the past, some large corporations have given their IP lawyers a goal of getting X number of patents by year end. That kind of goal is a direct consequence of the incentives of cost accounting. Nobody who really understands how inventing is done or how it creates value within a firm would ever demand that a certain number of patents be filed within a certain amount of time.”

Here is a man shining light on the cells that support the cancer that is eating the system. I’ve seen you on the boards before, but I must say I respect you more for having made a well thought out post for us on a topic that is new to these boards.

Mr. Martin here seems most likely to be one of the ultra rare and highly prized CPA’s with a JD, I would not take his word lightly.

Lowly, it seems Mr. Martin side stepped your question of what a low quality patent is when he responded they they likely occur more often when merely filed to pad out a balance sheet. Allow me to take a small stab at the answer.

A low quality patent (or application) is a patent with one or more of the following:

1. No patentable subject matter in the claims (especially relevant when the invalidating art is known at the time of filing)
2. Little to no patentable subject matter in the specification
3. Claims directed to inventions that are commonly known to those in the relevant art
4. Poorly drafted specification, drawing, or claims
5. Specification that is not wholly enabling
6. Claims directed to ineligable subject matter
7. Inequitable conduct commited during prosecution
8. Voluminous prosecution history estoppel
9. Claims that are an amalgamation of a very small number of easily combinable references
10. Specification showing no unexpected results (in the event 9 is present)

The list goes on ad infinitum, but those are some features that stand out.

The more features listed above that an application or patent has, the lower its quality. Many patents might contain one or two features, and some of the features might be remedied in prosecution, but ones with multiple features from that list definitely fall into a catagory of what can only be called a “low quality” patent. That is, if it ever issues.

I for one am surprised that one in the patent field would have a hard time imagining what is meant by the phrase. If anyone has some things to add to the list, feel free.

“Public Company X (PCX) purchased a patent for $1 million. In the patent purchase price allocation, PCX used the “relief of royalty valuation methodology” to estimate the fair value of the purchased patent at $10 million, which is being amortized over the potential useful economic life.
The carrying value of the patent at year’s end totaled $8 million, with a remaining life of approximately 16 years.”

I’m no accountant (but I play one on TV), but based upon your hypothetical, are you saying that PCX purchase Patent ‘123 for $1M, but puts it on the books for $10M? In increase in assets would mean an increae in revenues (and presumably profits, which are taxable). Of course, the patent is amortized over the life of the patent, which will reduce revenues (and presumably profits and taxes) down the road. If so, such a transaction will result in an increase in taxes in the short run to obtain a reduction in taxes over the long run. Given the time value of money, this doesn’t seem to be a good proposition.

Also, I don’t think the company’s accountants are going to buy into that valuation if there is no expectation that the patented product will enter the marketplace or that royalty revenues will be generated by the patent …. again, I’m no accountant, but that is how I read your hypothetical.

“In the past, some large corporations have given their IP lawyers a goal of getting X number of patents by year end. That kind of goal is a direct consequence of the incentives of cost accounting. Nobody who really understands how inventing is done or how it creates value within a firm would ever demand that a certain number of patents be filed within a certain amount of time.”

“The best way to have a good idea is to have lots of ideas.” Linus Pauling
“To have a great idea, have a lot of them.” Thomas Edison

I would hope that most here have an idea who Edison was, but for those unfamiliar with Pauling, his bio can be found here: link to en.wikipedia.org

Certain large corporations (and even much smaller businesses) look to file (and encourage their employees) to file as many legitimate patent applications as possible. Although obtaining many patents help to increase intangible assets in the long run, this is a side-effect of the endeavor.

Filing many applications have a couple direct consequences. First, going back to my two quotes, there is no way to easily separate the “wheat from the chaff” when it comes to patentable ideas. Although certain inventions jump out and scream “I’m really valuable,” some inventions do not until sometime later down the road. By encouraging many applications to be filed, these companies are not losing potential intellectual property because they failed to recognize (and thus dismissed) the long-term potential of an idea at the time of the idea’s germination.

Also, by instilling a culture of both innovation AND disclosure within the company, many good ideas that may have been disregarded by potential inventors reluctant to expose themselves to ridicule (e.g., “that is a bad idea!”) feel more comfortable bringing those ideas into the light of the day.

I have read of many instances in which a patent critic, upon seeing a particular patent, exclaims “I thought of that years ago!!!” However, despite having a patentable idea, this patent critic was likely never encouraged to file a patent or was afraid to for fear of rejection. One wonders whether these types of patent critics are critics because they have a fundamental problem with the system or because they are just unhappy that someone was able to get a patent on an idea that they (allegedly) thought up first.

Words of wisdom … all is not as it seems. To simply dismiss obtaining large patent portfolios as just a measure to increase the asset side of the balance sheet misses overlooks much. Also, this post merely touches only one of the many reasons other than increasing the asset value of the company for obtaining a large patent portfolio.

PCX’s managers (who are significant shareholders) pump the value of the company’s stock with breathless press releases trumpeting the enormous sums of money the company will make from licensing revenues. IDCC’s, whoops, I mean PCX’s managers sell their shares at the peak and disappear into the sunset.

I haven’t followed this thread but I think my question is possibly related.

Does the following make any sense to anyone?
Is the following another way to profit from patents?

Public Company X (PCX) purchased a patent for $1 million. In the patent purchase price allocation, PCX used the “relief of royalty valuation methodology” to estimate the fair value of the purchased patent at $10 million, which is being amortized over the potential useful economic life.
The carrying value of the patent at year’s end totaled $8 million, with a remaining life of approximately 16 years.

Assuming the patented invention never entered the market place, did PCX nonetheless profit from purchasing the patent for $1 million.

“Thus, most managers will pursue the easiest available route to growing their balance sheet.”

I agree with that. (What’s rational for the manager is not always what’s best for the firm, of course.)

But what does this have to do with patent litigation? Mr. Martin’s article begins with the question “Why do patents end up in litigation?” Are you suggesting that the answer is “Because there are too many of them (because managers are encouraged to file too many to grow the balance sheet)”?

“Thus, the system of cost accounting has given managers and investors the perverse incentive to aggregate thousands of patents, inflating their balance sheets, much like we saw prior to the subprime mortgage debacle.”

I understood the phenomenon. Thanks for explaining causation.

Dear Mr. Bloom:

The problem with “rational economic actors” is that they don’t follow the impartial economist’s sense of rationality or of fair-dealing. Instead, they follow their individual incentives. Most managers are rewarded for balance sheet growth. Most managers are the type of people who know how to succeed, regardless of restraints on their behavior. (“overcoming obstacles”). Most managers also value efficiency. (“most reward for least investment”). Thus, most managers will pursue the easiest available route to growing their balance sheet.

Won’t rational economic actors see through any accounting scheme and assess a patent’s value independently?

This is a very, very important point. The rational hypothesis, by itself, is not enough to explain why or when groups will cooperate. I have an extended discussion of how Thomas Schelling was the first to make this point on my blog:

You know what we call privately-owned/closely-held corps that invest in IP in this country? Startups.

Why do you think big companies like Microsoft pay $100M for the privilege of having a motley band of engineers join their team (see, e.g., the recently announced acquisition of Powerset)? Because of the IP.

@Leopold Bloom:

Sure the Sumerians knew how to do it. But it was the Venetians that understood it well-enough to explain it.

At first I didn’t agree w/ Mr. Martin — but the more I think about it, more I’m coming around.

Although folks at many levels understand (to some degree) inventing and how it is done and why it creates value, they still have their budgets to spend and their metrics to meet. Those budgets and metrics are, I think, created because of the incentive to show good results under cost acctg.

Even the very top of the food chain has to report under the metrics of cost acctg. to the shareholders. Even a fully-aware CEO will spurn the right answer for the answer that gives the best metrics–this will maximize share price (i.e., shareholder value) at least in the short run.

Therefore “thou shalt file 469 patent applications in FY 2009.”

If this is correct, then perhaps privately owned/closely-held corps have better IP metrics?

Mr. Martin, I know you’re very fond of the 15th-century Venetians, but I believe evidence of double-entry bookkeeping is found in Sumerian records that date back more than 4000 years.

Thanks for the article. It’s interesting, but it seems to me that your theory has the accounting tail wagging the economic dog. Won’t rational economic actors see through any accounting scheme and assess a patent’s value independently? In at least one sense, a patent is like any other asset – if I think your patent is worth more in my hands than it is in yours, then we can come up with a deal. Your bookkeeping will have very little influence on my valuation of your patent.

Patents, however, are unlike other assets in that they are inherently unproductive. (I’m talking about after the fact – yes, I believe that the promise of a patent can be a stimulus.) The sole functions of a granted patent are to either stop someone’s economic activity, or to place a tax on it. It shouldn’t be a surprise that targets of a patentee are reluctant to simply accept this tax, and thus end up in litigation.

A patent that is filed for the purpose of padding out a balance sheet asset account will be lower quality, on average, than a patent filed by a startup company to protect its family jewels.

It’s not possible to be exact with these measurements of quality. But what I’m trying to do here is point out that a valuable invention should have a measurable effect beyond simply increasing the size of a balance sheet asset account.

Can you explain to me what constitutes a “low quality patent?” Dudas talks about it. You’re talking about it. Exactly what is it? An application containing no patentable subject matter? Poorly drafted claims? What?

One of the weirdest things about economic incentives is that groups will do things because of them without any single member in the group being completely aware of the causes of or consequences to the incentives.

I should have added a P.S. to the post — the incentives of cost accounting are probably a big driver of the enormous number of low quality patents filed at the PTO. In the past, some large corporations have given their IP lawyers a goal of getting X number of patents by year end. That kind of goal is a direct consequence of the incentives of cost accounting. Nobody who really understands how inventing is done or how it creates value within a firm would ever demand that a certain number of patents be filed within a certain amount of time.

“Thus, the system of cost accounting has given managers and investors the perverse incentive to aggregate thousands of patents, inflating their balance sheets, much like we saw prior to the subprime mortgage debacle.”

Simple “profits,” which should be part of any rational balance sheet, should be distinguished from monopoly profits/rents or profits that have little relation to the marginal cost per unit of production. Patent royalties are a kind of monopoly profit. And patent “assets” are not static or tangible assets, therefore the model Mr. Martin suggests is untenable.

I take some issue with the assertion that trillions of dollars in legal rights are exchanged without litigation. If you mean mere transfer of assets, then that would fall into a different category from patents or purely putative rights in my opinion. By purely putative, I mean rights that are distinct from ownership, rights that, but for litigation or the threat of litigation, would not be realizable. The aggregate value of patent rights that are litigated is not an insignificant number.

However, it seems to me that patent rights fall into the quasi-putative realm. In other words, presumptions of validity notwithstanding, in many cases, without litigation or the threat of litigation, patent rights are not perfected rights.

In theory, patent protection should allow manufacturers to reap monopoly profits at least for a limited time to recapture certain unrecoverable costs of development, which should incentivize development.